33
Technological Revolutions and Debt Hangovers: Is There a Link? Dan Cao and Jean-Paul L’Huillier * December 2012 Abstract Using a model in which anticipations about the future determine current spend- ing, we take a medium-frequency look at time series data around the Great Recession, the Great Depression, and the Japanese crisis of the 1990s. This leads us to highlight some common features of these three episodes: in all three cases we observe a boom followed by a slowdown in permanent productivity, with a peak about 10 years before the start of the recession. Spending follows a similar pattern, but with an important lag, that we estimate to be of 5 years. In our model, spending adjusts slowly due to imperfect information. Since spending remains high when productivity has already slowed down, a large accumulation of debt ensues. When agents finally recognize the slowdown of productivity, a deleveraging process takes place. The deleveraging drags the economy into a long consumption slump. The whole process, from the increase of productivity rates to the start of the decline in consumption, takes about 25 to 30 years. In the three cases, the pickup of productivity coincides with previously documented economy-wide technological changes. * Georgetown University and Einaudi Institute for Economics and Finance. Preliminary working paper version. We thank Effi Benlemech, Olivier Blanchard, Jean Flemming, Pierre-Olivier Gourinchas, Luigi Guiso, Francesco Lippi, Enrique Mendoza, Lubos Pastor, Luigi Pistaferri, Michael Powell, Alp Simsek, Peter Temin, Daniele Terlizzese, Nicholas Trachter, and Pietro Veronesi for useful discussions. 1

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Page 1: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

Technological Revolutions and Debt Hangovers: Is

There a Link?

Dan Cao and Jean-Paul L’Huillier∗

December 2012

Abstract

Using a model in which anticipations about the future determine current spend-

ing, we take a medium-frequency look at time series data around the Great Recession,

the Great Depression, and the Japanese crisis of the 1990s. This leads us to highlight

some common features of these three episodes: in all three cases we observe a boom

followed by a slowdown in permanent productivity, with a peak about 10 years before

the start of the recession. Spending follows a similar pattern, but with an important

lag, that we estimate to be of 5 years. In our model, spending adjusts slowly due to

imperfect information. Since spending remains high when productivity has already

slowed down, a large accumulation of debt ensues. When agents finally recognize the

slowdown of productivity, a deleveraging process takes place. The deleveraging drags

the economy into a long consumption slump. The whole process, from the increase

of productivity rates to the start of the decline in consumption, takes about 25 to

30 years. In the three cases, the pickup of productivity coincides with previously

documented economy-wide technological changes.

∗Georgetown University and Einaudi Institute for Economics and Finance. Preliminary working paperversion. We thank Effi Benlemech, Olivier Blanchard, Jean Flemming, Pierre-Olivier Gourinchas, LuigiGuiso, Francesco Lippi, Enrique Mendoza, Lubos Pastor, Luigi Pistaferri, Michael Powell, Alp Simsek,Peter Temin, Daniele Terlizzese, Nicholas Trachter, and Pietro Veronesi for useful discussions.

1

Page 2: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

“Shifts in the economy are rarely forecast and often not fully

recognized until they have been underway for some time.”

Larry Summers, Financial Times, March 25, 2012

1 Introduction

A medium frequency look at the three most important private-debt recessions in

developed economies reveals that they have all been preceded by periods of great

technological innovation and economic transformation. Specifically, the recent Great

Recession in the United States was preceded by a technological revolution, happening

in the late 1990s, related to the Information Technology (henceforth IT) (Atkeson

and Kehoe 2007; Pastor and Veronesi 2009). Similarly, the Japanese debt crisis of

the 1990s was preceded by a period of unprecedented industrial innovation in the

1980s. During this period, Japanese corporations developed and exported several

electronic products that were massively consumed in many parts of the world, for

instance the walkman, the VHS, the Betamax, and ATARI. We view this period as

characteristic of a technological revolution concentrated in Japan. Finally, before

the Great Depression, the United States witnessed the so-called 2nd Industrial Rev-

olution, happening at the beginning of the 20th century. Two key general purpose

technologies here were the combustion engine and electricity: The combustion en-

gine made possible the mass production of cars for the American household by the

Ford Motor Company, starting in 1909, and about 70% of household and corporate

electrification happened approximately between 1910 and 1925.

Motivated by these facts, we set out to write a model in which technological

revolutions lead to debt crises. Our goal is to understand how these facts can be

rationalized in an optimizing framework. A key feature of our model is that an-

ticipations about the future determine output, similar to the recent ‘news’ business

cycles literature (Beaudry and Portier 2006; Christiano, Ilut, Motto, and Rostagno

2008; Jaimovich and Rebelo 2009). Importantly, these anticipations here are formed

based on noisy information. Our main mechanism is the rational formation of beliefs

about the future around a technological revolution.

The joint dynamics of the technological revolution and belief formation lead to a

slow moving process that takes twenty to twenty-five years to be completed. Because

our goal is to explain this process, we focus exclusively on medium frequencies. The

process can be summarized by the following sequence of events. First, a technological

2

Page 3: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

revolution creates a boom in aggregate productivity. This technological boom slowly

creates a wave of optimism in the economy, which increases spending. Because of

noisy information, spending tends to coincide with the end of the revolution. The

end of the revolution implies a drop in the growth rates of productivity, together

with a decrease in income. High spending combined with the decrease in income

imply a wedge that creates an accumulation of debt. The increasing stock of debt

leads of a debt crisis and a consumption slump due to a deleveraging process.

In our model, spending is simply characterized by consumption through a stan-

dard permanent income hypothesis combined with noisy signals about future income.

In order to keep our framework as transparent as possible, we abstract away from

investment and stock market valuation.

We use our model to interpret the data through structural estimation. The

estimation of our model delivers three main results. First, there is a significant

delay in the adjustment of anticipations about the future due a high amount of

noise. This implies that spending dynamics considerably lag productivity dynamics,

peaking about five years after the peak in productivity. Second, there is a large

accumulation of debt that coincides with the peak in spending and the slowdown

of productivity. The reason is the long delay in the adjustment of beliefs about

the future, which in our model determine consumption and spending. Third, the

deleveraging process after a technological revolution – necessary to return to steady

state after the build-up of debt – is notoriously slow. The reason is that the end of

the technological revolution produces a decline in the growth rates of productivity.

Because in our economy productivity creates income for the representative agent,

this agent finds itself trapped in an adverse scenario for two reasons: high debt, and

low income. Therefore, the ensuing deleveraging process is slow. In fact, a simulation

of our estimated model suggests that it takes 15 to 20 years for consumption to get

back to its steady state level. We name this situation a debt “hangover”, by analogy

to a post-party “recovery”. According to this analogy, U.S. consumers would have

“partied” between, say 1998 and 2005, and would then need to “recover”, by bringing

their debt/output ratio to steady state.

3

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2 The Model

2.1 Productivity process and Information Structure

We model an open economy similar to Aguiar and Gopinath (2007), adding a “news

and noise” information structure (Blanchard, L’Huillier, and Lorenzoni 2012, hence-

forth BLL).1 Specifically, productivity at (in logs) is the sum of two components,

permanent, xt, and transitory zt:

at = xt + zt .

Consumers do not observe these components separately. The permanent compo-

nent follows the unit root process

∆xt = ρ∆xt−1 + εt . (1)

The transitory component follows the stationary process

zt = ρzt−1 + ηt . (2)

The coefficient ρ is in [0, 1), and εt and ηt are i.i.d. normal shocks with variances

σ2ε and σ2

η. Similar to BLL, we assume that these variances satisfy

ρσ2ε = (1− ρ)2 σ2

η , (3)

which implies that the univariate process for at is a random walk, that is

E[at+1|at, at−1, ...] = at .

This assumption is analytically convenient and, as will be seen below, also broadly

in line with actual productivity data. To see why this property holds, note first that

the implication is immediate when ρ = ση = 0. Consider next the case in which ρ

is positive and both variances are positive. An agent who observes a productivity

increase at time t can attribute it to an ε shock and forecast future productivity

growth or to an η shock and forecast mean reversion. When (3) is satisfied, these

two considerations exactly balance out and expected future productivity is equal to

1Boz, Daude, and Durdu (2011) use a similar framework. We simplify it further by removing capitaland investment, which allows us to derive a tight connection to the New Keynesian model (see Subsection2.3).

4

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current productivity.2

Consumers have access to an additional source of information, as they observe a

noisy signal about the permanent component of productivity. The signal is given by

st = xt + νt , (4)

where νt is i.i.d. normal with variance σ2ν .

We think of εt as the “news” shock, because it builds up gradually, has permanent

effects on productivity and delivers (noisy) information about the future through the

signal. We think of νt as the “noise” shock.

2.1.1 Slow Adjustment of Beliefs and Technological Revolutions

Here we focus on an important property of the signal extraction problem for our

purposes.

First, we borrow the idea from Greenwood and Jovanovic (1999) (among others)

that “technological revolutions come in waves”. According to this idea, the start of

a technological revolution should create an increase in the growth rate of permanent

productivity – away from the old, deterministic trend – and the end of a technological

revolution should create a decrease in the growth rate of permanent productivity –

away from the new trend.

Turning to the implications of these movements of the permanent component of

productivity for beliefs, notice that agents, trying to forecast the future path of xt,

will form beliefs about the level of x at infinity

xt+∞ ≡xt − ρxt−1

1− ρ(5)

using a Kalman filter. As will become clear, in the model these beliefs will largely

determine beliefs about long-run income, and therefore consumption.3 Denoting as

xτ |t ≡ E[xτ ] the conditional expectation of xτ on information available at time t, we

have

xt+∞|t =xt|t − ρxt−1|t

1− ρ. (6)

Because of noisy information, agents will be slow to adjust their beliefs xt+∞|t.

2See BLL for the proof.3Movements in the real interest rate will also affect consumption, but they turn out to be of little

importance in the calibrated model.

5

Page 6: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

Figure 1: An Example of a Technological Revolution

In particular, they will be slow to adjust their beliefs after the decrease of ∆xt and

will remain “optimistic” for a while.

For illustrative purposes, consider the example of a technological revolution given

by Figure 1. The upper panel of the figure plots off-trend permanent shocks, and

the lower panel plots the implied long run levels of the permanent component x∞.

Notice that the second off-trend shock appears here as negative, however, this shock

is in fact positive – but smaller than the first one – once the deterministic trend is

added back. The technological revolution initially increases the long run level of the

permanent component, and then decreases it in off-trend terms.4 As we will show

below, our structural estimations, which allow us to estimate permanent shocks, will

give support to this view of technological revolutions for the three cases we consider.

Figure 2 sketches the evolution of beliefs around this technological revolution,

represented by the dotted line in the lower panel. Agents slowly learn about the

increase in the long run level of the component, and about the subsequent decrease.

Overall, the adjustment of beliefs lags the actual changes in the permanent compo-

nent, which is the key property needed for our results. Notice that the persistence of

the process for ∆xt given by ρ implies a persistence of beliefs which is compounded

to the lag implied only by noisy information.5

4In this example, the technological revolution has a total positive effect on the off-trend level of thelong run permanent component.

5One may ask why agents in this economy do not anticipate the second (negative) shock when learningabout the first one. We think about these technological revolutions as happening rarely, for instance

6

Page 7: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

Figure 2: Beliefs Around a Technological Revolution

2.2 Consumption, Production and Net Exports

We now describe the rest of the model. A representative consumer maximizes

E

[ ∞∑t=0

βt(

ln (Ct)−ϕ

1 + φN1+φt

)]where E[ · ] is the expectation operator conditional on information available con-

temporaneously. The maximization is subject to

Ct+Bt−1= Y t+QtBt , (7)

where Bt is the external debt of the country and Yt is the output of the country.

Output is produced using only labor through the linear production function:

Yt = AtNt. (8)

In order to obtain the stationarity of the loglinearized model around the steady

state, we assume that the interest rate that the representative consumer faces is

increasing in the total amount of external debt (Schmitt-Grohe and Uribe 2003):

once every century. Accordingly, in our simple specification of the evolution of technology agents are“surprised” by the sharp slowdown of aggregate productivity implied by the second shock.

7

Page 8: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

1Qt

= Rt = R∗ + ψ

{eBtYt−b − 1

}, (9)

normalized debt.6

The two first-order conditions from the optimization problem of the consumer

are:

1. Intertemporal

1Ct

= βRtE

[1

Ct+1

], (10)

2. Intratemporal

At =ϕNφ

t1Ct

. (11)

2.2.1 Normalization and Loglinearization

Steady State. We look for a steady state in which the following variables (nor-

malized and non-normalized) are constant: c = C/A, y = Y/A, N , b = B/Y , R,

and Q. We assume that the steady state level of normalized debt b is determined

exogenously.7

From the intertemporal condition (10), we have

1C

= βR1C+

,

where the subscript + is used to denote value one period ahead. Equivalently,

then

1C/A

= βRA

A+

1C+/A+

.

Given that c = C/A = C+/A+ in the steady state, it implies that

1 = βRA

A+, (12)

6The fact that the international interest rate does not adjust to developments in the domestic economymakes this essentially a small open economy model. In Subsection 2.3 we consider a two-country openeconomy model where the international rate is endogenous. At the limit when ψ → 0 both models areequivalent regarding the behavior of consumption, and therefore for parametrizations typically used inthis literature (fairly small ψ, see Aguiar and Gopinath 2007) both models deliver similar results. SeeProposition 1.

7Aguiar and Gopinath (2007) make the same assumption.

8

Page 9: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

or

R =1β

.

The resource constraint (7) gives

C +B = Y +1RB+ ,

orC

A+B

A=Y

A+

1R

B+

A+

A+

A.

The intra-temporal first-order condition (11) implies

1C/A

= ϕNφ . (13)

Moreover, using and (12) and (8), we can simplify the budget constraint in the

steady state further to

ϕNφ + b = N + βb .

From this equation, given b, we can solve for the steady state level of employment,

N . Given N , we can solve for c using (13) and then y.

Loglinearization. Define

ct ≡ logCt − logAt − log (C/A) ,

nt = logNt − logN ,

rt ≡ logRt ,

and

bt =BtYt− B

Y,

nxt =NXt

Yt− NX

Y.

To loglinearize the intertemporal condition

9

Page 10: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

1Ct

= βRtE

[1

Ct+1

],

we proceed as follows:

1Ct

AtAt

= βRtE

[1

Ct+1

At+1

At+1

],

to obtain

ct = −rt + E[ct+1 + ∆at+1] .

The loglinearization of the intratemporal condition is immediate

ct + φnt = 0 .

Similarly for the production function:

yt = nt ,

and the interest rate equation

rt = ψ · bt .

Approximating the resource constraint delivers[C

A(ct + 1)

] [A

Y(−yt + 1)

]+NX

Y+ nxt = 1 ,

which leads to

ct +1

C/Ynxt = yt .

The current account surplus is

NXt = Bt−1 −QtBt ,

and therefore, approximating

NX

Y+nxt =

[B

Y+ bt−1

] [Y

A(yt−1 + 1)

] [A

Y(−yt + 1)

][−∆at + 1]−

[1R

(−rt + 1)] [

B

Y+ bt

]to obtain finally

10

Page 11: Technological Revolutions and Debt Hangovers: Is There a Link?faculty.georgetown.edu/dc448/draft 2 CL FINAL.pdfthat \technological revolutions come in waves". According to this idea,

nxt = bt−1 − βbt +1− C/Y

1− β(yt−1 − yt −∆at + βrt) .

2.2.2 Summary of Loglinearized Model and Simulation

The loglinearized model has 6 endogenous variables: ct, yt, nt, st, rt, and bt. The

model is given by the equations for the shock processes and 6 equations:

ct = −rt + E[ct+1 + ∆at+1] , (14)

ct + φnt = 0 , (15)

yt = nt , (16)

rt = ψ · bt , (17)

ct +1

C/Ynxt = yt , (18)

nxt = bt−1 − βbt +1− C/Y

1− β(yt−1 − yt −∆at + βrt) , (19)

Figure 3 shows a simulation of the model for given parameter values. The figure

shows the responses of consumption ct, net exports nxt (or equivalently in this model,

the current account), and external debt bt, to a one-standard deviation increase in

εt (the permanent technology or “news” shock). The time unit on the x-axis is

four quarters (one year). The scale of productivity is relative percentage deviations

from steady state plus 1, times 100. The scale of net exports is absolute percentage

deviation from the steady state value of net exports-to-output, NX/Y . The scale of

the debt-to-output ratio is absolute percentage deviation from the steady state value

of debt-to-output, b. The parameter values are those obtained when estimating the

model using data for the United States (1990–2010). The discount factor β is set

at 0.99. The inverse of the Frisch elasticity of labor supply is set at 2. The value

of ψ is taken from Aguiar and Gopinath (2007) (0.0010).8 The steady state value

of the consumption-to-output ratio C/Y is estimated at 0.9979. The parameter ρ is

estimated at 0.98, implying slowly building permanent shocks and slowly decaying

8Schmitt-Grohe and Uribe (2003) use a similar value.

11

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transitory shocks. The standard deviation of productivity growth, σu, is estimated

at 0.63. These values for ρ and σu yield standard deviations of the two technology

shocks, σε and ση, equal to 0.01% and 0.62%, respectively. The standard deviation

of the noise shock, σν , is set to 10.80%, implying a fairly noisy signal.9

Figure 3: Impulse Response Functions After Permanent Technology Shock.

In response to a one-standard-deviation increase in εt, the permanent technology

shock, productivity increases slightly on impact, and then gradually continues to

increase until it reaches a new long-run level. This sustained increase is slow; in

fact, half of the productivity increases are reached only after 7 years. Initially, net

exports rise, mainly because productivity increases faster than beliefs about long

run productivity. This is a reflection of the high amount of noise in this simulation.

After 5 years net exports fall, because agents have received enough “news” and a

standard income effect kicks in. This is translated into a sharp accumulation of

external debt. In the long run, productivity reaches a new level (at 1.063) and net

exports and the debt-to-output ratio go back to zero.

2.3 Some Useful Convergence Results

Here we establish that the loglinearized model presented here (a version of Aguiar

and Gopinath 2007 without capital) has arbitrarily similar consumption dynamics

9It is important to underline that these values are of a similar order of magnitude as those obtained inBLL, and also to those estimated using data for either Japan or the Great Depression. The reasons arepresented in Subsections 2.3 and 3.

12

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to a closed-economy New Keynesian model with a high degree of price stickiness.10

Proposition 1 (Convergence to a Closed Economy New Keynesian Model)

If C/Y = 1, the consumption dynamics in the economy represented by equations (14)

to (19) approaches the consumption dynamics of a closed economy New Keynesian

model with highly sticky prices as ψ tends to 0 and β tends to 1.

The proof is in the appendix. The intuition behind this result is that when φ

is small, the interest rate is not very sensitive to deviations of consumption from

the steady state. Similarly, in a New Keynesian economy with high degree of price

stickiness, inflation is not very sensitive to deviations of consumption from the steady

state, and by implication the nominal interest. Therefore, at the limit, both models

have similar consumption dynamics. Notice of course that this result is independent

of the degree of noise σs in the model.11

This limiting result is useful in practice because, for parameters usually consid-

ered in the literature (Schmitt-Grohe and Uribe 2003; Aguiar and Gopinath 2007),

these limiting conditions are numerically satisfied. Indeed, for a discount factor

β = 0.99 and a reaction of the interest rate rt to deviations from the steady state of

the debt-to-output ratio φ = 0.0010, the dynamics of our model and the dynamics

of a New Keynesian model with highly sticky prices (BLL) are similar.

An immediate corollary of this main result – important to justify the use of this

model for the U.S. economy and Japan – is that our model, in which the world interest

rate R∗ is fixed, has also arbitrarily close dynamics as a two-country open economy

model. For parameters usually considered in the literature (mainly ψ = 0.0010),

then, our model is a good approximation of a two-country model in which R∗ is

endogenous. We develop this theme further in the section presenting the results of

structural estimation.

3 Empirical Results

In this section we report empirical results for the three episodes considered. Our goal

is to look at the data through the lens of our model, and compare the lessons from10BLL use such a model to estimate the degree of imperfect information in the U.S. economy (1948-

2011), and extend the framework to a model with estimated price stickiness that incorporates otherfrictions frequently used in the literature (Christiano, Eichenbaum, and Evans 2005; Smets and Wouters2007).

11The reason β needs to go to 1 is just an artifact of the loglinearization and has no economic content.See the proof for the details.

13

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each episode. For instance, the estimated model can be used, in each of these cases,

to back out estimated series for the long-run permanent component of productivity,

and series of corresponding contemporaneous consumer beliefs. These series can be

then used to test our hypothesis on two dimensions. First, the estimated permanent

component of productivity should feature an increase, together with a subsequent

decrease. Second, consumers’ beliefs should lag these movements, adapting slowly

on the upside, peaking after the permanent component, and then reverting back.

3.1 Structural Estimation

For the Great Recession, we use the open economy model presented in the previous

section and fix a subset of the parameters to conservative values that we draw from

the literature. These parameters are shown in Table 1. An important parameter

for our purposes is ψ, which we fix to 0.0010, as Schmitt-Grohe and Uribe (2003)

and Aguiar and Gopinath (2007). The remainder set is composed by the steady

state debt-to-output ratio B/Y , which we estimate at 0.2143 using flow of funds

data, implying a value of the consumption-to-output ratio C/Y = 0.9979, and the

informational parameters (the persistence of the technology processes ρ, the standard

deviation of productivity innovations σu, and the standard deviation of noise shocks

σs). These informational parameters are estimated using maximum likelihood. From

BLL we know that, in this type of model, identification of these parameters is usually

obtained – in the sense of finding a unique maximum for the likelihood function –

when the other parameters of the model are fixed and two time series are used, as

for instance a series for productivity and a series for consumption. Therefore, we

limit ourselves to this approach without recurring to Bayesian statistics.

Parameter Description Value

φ Inv. Frisch Elasticity 2β Discount Factor 0.99ψ Sensitivity Interest Rate 0.0010

Table 1: Fixed Parameters.

In the case of Japan, we feel less comfortable with a model in which the domestic

economy finances consumption through external liabilities. Moreover, for both Japan

and the Great Depression, and especially for the Great Depression, we do not have a

good sense of how the consumption boom was financed. Therefore, we limit ourselves

to a demand determined economy without explicit borrowing and lending, in which

14

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anticipations about the future determine output (the simple New Keynesian economy

of BLL). Notice however that, having established Proposition 1, this economy should

behave similarly to the open economy model for the values of Table 1. We have

verified this claim in a number of ways, in particular by checking that all of the results

mentioned here would be similar if instead we had estimated the open economy model

for both Japan and the Great Depression.

Data and Observationally Equivalent Full Information Model. In

the case of the U.S. 1990–2010, the time series used are (the logarithm of) labor

productivity and per capita real net exports. We use quarterly data. In the case of

Japan, the time series used are (the logarithm of) labor productivity and national

accounts per capita real consumption.12 We use quarterly data.

In the case of the U.S. 1919-1933 we do not have data for net exports, instead

we use private consumption from the Gordon-Krenn data set.13 Gordon and Krenn

(2010) used the Chow-Lin method (Chow and Lin 1971) for interpolating annual

national accounts series and obtain cyclical variation at quarterly frequency, thereby

obtaining an estimated series for GDP components. In order to obtain a series for

labor productivity, we obtained an estimate for GDP from the Gordon-Krenn data

set, and we used the Kendrick data set for employment, using a linear interpolation

out of this annual series. The labor productivity, net exports and consumption series

are detrended prior to the estimation, by separately removing the average growth

rates from each of them.

Following BLL, we exploit the existence of an observationally equivalent full

information model to the model with noisy information. This immensely facilitates

the implementation of our estimation by allowing us to use standard computational

tools. Our loglinearized model can be represented in state space form and estimated

through Maximum Likelihood. Our environment is parsimonious and therefore there

is no need to recur to Bayesian methods. In fact, we know that in all estimations

we hit a unique global maximum for the likelihood function. This is of course an

advantage because it makes the exercise transparent, and therefore it is fairly easy

to get a sense of how our model fits the data.

Results. Table 2 contains the parameter estimates. The persistence parameter ρ

was estimated at 0.98 both in the case of the Great Recession and Japan, and at 0.95

12For more details, see Appendix A.1.13In this case our sample length choice is restricted by the fact that we do not have quarterly private

consumption data before the end of World War I in 1918.

15

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in the case of the Great Depression, implying very persistent processes both for the

permanent and the transitory components of productivity. The standard deviation

of productivity was estimated at 0.69% in the case of the Great Recession, at 0.98%

in the case of Japan, and at 1.70% in the case of the Great Depression. Given the

random walk assumption for productivity, the high values of ρ imply a standard

deviation for permanent technology shocks that is fairly small, of 0.01%, 0.02%, and

0.09% respectively, and a fairly big standard deviation for the transitory technology

shock, of 0.66%, 0.97%, and 1.66% respectively. The standard deviation of noise

shocks is large, 10.80%, 12.08%, and 10.70%, implying fairly noisy signals.14 The

fact that permanent changes in productivity tend to be small compared to the size of

transitory shocks, and that the amount of noise in the signal is large, suggests that

learning is slow, because both at and st are fairly uninformative signals about xt.

This illustrates the major signal extraction problem that consumers face according

to our estimation.

Great GreatParameter Description Rec. Japan Depr.

ρ Persistence tech. shocks 0.98 0.98 0.95σu Std. dev. productivity 0.63 0.98 1.70σv Std. dev. permanent tech. shock 0.01 0.02 0.09σz Std. dev. transitory tech. shock 0.62 0.97 1.66σs Std. dev. noise 10.80 12.08 10.70

Table 2: Parameter Estimates.

The simplicity of our model and Proposition 1 provides a fairly clear intuition of

the identification of these parameters. Indeed, the limiting model admits a closed

form VAR representation, together with some equations for other moments needed

to identify the parameters. For the details see BLL. In a nutshell, the persistence

ρ is identified by the covariance between the productivity-to-consumption ratio and

future changes in productivity. The intuition is that according to our model agents

should be able to forecast these changes, and these forecasts are reflected in con-

sumption. On average, the lower the productivity-to-consumption ratio, the larger

the subsequent increases of productivity, given that high consumption should on

average be associated with an increasing path of the permanent component of pro-

ductivity. For a given variance of the ratio, the higher the covariance, the larger

14Notice that the signal is about the level of the permanent component and therefore it is misleadingto directly compare the size of the noise shocks to the size of permanent shocks.

16

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are permanent shocks with respect to transitory shocks, and the lower ρ.15 Having

pinned down ρ, the noise in the signal can be identified by the variance of changes

in consumption with respect to the variance of changes in productivity. For a given

ρ, the smaller the variance of the signal σ2s , the more consumption changes due to

permanent shocks because of the income effect, and the more volatile is consump-

tion. Since in our estimation ρ is estimated as large, the income effect is large and

we need a high degree of noise to limit the reaction of consumption and match the

data.

The state-space representation of the estimated model can be used in order es-

timate the shocks and states of the model using a Kalman smoother16. Among the

states, the most interesting are the evolution of the state variable xt (permanent

component of productivity), and corresponding contemporaneous consumers’ beliefs

xt|t = E[xt].

Figure 4 plots our estimated permanent technology shocks for the case of the

Great Recession. Consistent with our idea of the effects of a technological revolution

– spelled out in the previous section – we estimate a series of positive shocks in

the early 1990s, up to 1997, and a subsequent series of (off-trend) negative shocks.17

Figure 5 plots our estimated transitory shocks (upper panel) and our estimated noise

shocks (lower panel). These series of shocks do not show any particular pattern.

15It is possible to show that on average this relationship is not affected by the degree of noise, giventhat the analytic expression takes into account the variance of this ratio.

16A Kalman smoother is a Bayesian filter that uses all the sample (as opposed to the Kalman filter,which uses only contemporaneous and past observables) to compute ex-post estimates of the states of thesystem (see Hamilton 1994, pp. 394–397).

17The serial correlation of our estimated permanent shocks might seem a violation of the white noiseassumption about these shocks, however, it is just a reflection of the invertibility problem present in thismodel and discussed in detail in BLL.

17

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Figure 4: Smoothed permanent shocks (U.S. 1990-2010).

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Figure 5: Smoothed transitory and noise shocks (upper and lower panel respectively) (U.S.1990-2010).

Figure 6 plots a historical decomposition of series (5) and (6) (the long-run level

of the permanent component as of time t and consumers’ contemporaneous beliefs as

of time t) when only the effect of estimated permanent shocks is taken into account.

The long-run component is plotted using a dotted black line, and beliefs are plotted

using a solid blue line. The (detrended) long-run component has an inverse-V shape,

consistent with the idea of an acceleration of productivity (the upward slopping

region), followed by a deceleration (the downward slopping region), and peaking

around 1998. Beliefs follow a similar pattern but with a lag, peaking around 2002.

A possible out-of-sample check of the series of beliefs in Figure 6 can be done by

comparing it to survey evidence. For instance, Consensus Forecasts publishes trend-

growth expectations 6–10 years ahead for several countries. Taking the difference of

the forecast for the U.S. and a weighted forecast aggregate other available countries in

the data set gives the series plotted on the lower panel of Figure 7, that we reproduce

from Hoffmann, Krause, and Laubach (2011) (p. 6). In the upper panel we plot our

beliefs series, aligning the time axis to the Hoffmann et al. (2011) series. It is quite

remarkable that such a simple model is able to produce realistic predictions regarding

aggregate beliefs over the sample: A simple qualitative comparison between the two

19

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Figure 6: Historical decomposition of long-run component of productivity (black dottedline), and consumers’ contemporaneous beliefs about it (solid blue line), permanent shocks,(U.S. 1990-2010).

series reveals that in both cases a representative agent seems to have been most

optimistic around 2002–2004.

An issue that arises here concerns the sharp decline in several U.S. stock market

indexes around 2001. In a model where stock prices are driven by beliefs about

the future, this decline, taken at face value, constitutes a challenge to our story.

However, some care is needed when interpreting this decline in the context of our

model. First, depending on which index one looks at, the decline and the related

financial turmoil around 2001 were much less important than in 2008. For instance,

a look at the evolution of the Dow Jones Industrial Average supports the claim that

its drop around 2001 was small compared to its drop starting in 2008. As such, the

decline around 2001 could be the reflection of a high frequency event – aggravated

perhaps by some orthogonal events as the September 11th terrorist attacks – that

our medium frequency focus cannot possibly explain. Also, similar declines in the

stock market did not happen in other episodes we consider here. For instance, in the

case of the Great Depression, the stock market collapsed when the recession started

and not before. Second, the crash of the dot-com bubble could have other roots than

beliefs about long-run productivity. For instance, according to Pastor and Veronesi

(2009), the adoption of a new technology can create time-varying shifts in discount

rates that can contribute to bubble-like patterns in stock prices. Specifically, a

technological revolution can generate bad news about “systematic risk”, leading to

20

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Figure 7: Out-of-sample check: comparison of historical decomposition of beliefs (upperpanel, solid blue line) and survey evidence on growth forecasts (lower panel, dotted blueline, reproduced from Hoffman et al. 2011).

an ex-post drop in stock prices. We plan to investigate this issue more deeply in

future research.

The estimated shocks and states for Japan and the Great Depression have similar

shapes and for brevity we do not report them. Instead, we now focus on a feature of

the data that delivers estimated levels of the permanent component in the long run

and beliefs as shown in Figure 6.

3.2 Dynamics of the Productivity-to-Consumption Ra-

tio

A way to understand the results summarized by Figure 6 – the early pickup of

permanent productivity, the delay in the adjustment of beliefs, and the implied

lagged adjustment of consumption – is to look at the dynamics of the productivity-

to-consumption ratio over the period 1990–2010, plotted in Figure 8. Productivity

is the ratio of GDP divided by employment. Consumption is NIPA consumption

divided by population. The series plotted is the logarithm of the ratio of productivity

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to consumption. The vertical axis is centered around the average of the ratio over

the period considered.

As the figure shows, the ratio has relatively high values at the start of this time

window, with a slight increasing portion between 1990 and 1992. This is because

during this period productivity is growing at a higher rate than consumption. The

ratio starts declining around 1992, and this decline becomes more dramatic starting

in 1997, where consumption grows at a considerably stronger rate than productivity.

The ratio reaches its lowest point around 2007, after which a “correction” starts in

which the ratio quickly goes back to its level from 20 years earlier. The correction is

dramatic and coincides with the start of the Great Recession in 2007. Overall, the

ratio appears to follow a slow moving “wave”.

Importantly, these dynamics in the ratio are not due solely to the behavior of

consumption. In fact, aggregate productivity growth rates are declining over the

period – on average 1.87% from the first quarter of 1990:1 to the first quarter of

2005, dropping to 1.18% later on – a feature of the data consistent with the idea of

a technological revolution happening at early stages of the time period considered.

Figure 8: Productivity-to-consumption ratio, in logs (U.S., 1990-2010)

Figure 9 plots the same ratio for Japan. In this case we can see a more gradual

increase of the ratio from its average over the period considered, reaching a peak in

1985. From this point on, the average growth rate of consumption is higher than the

growth rate of productivity, and therefore the ratio decreases up to 1994. The lowest

point of the ratio is reached in 1997, after which an upward movement brings the

ratio back to its level in 1975, suggesting that similar to the previous case, the ratio

followed a slow moving “wavy” path. Similar to the case of the Great Recession,

Japanese growth rates of productivity are declining over the period: on average

22

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3.22% between the first quarter of 1975 and the first quarter of 1990, and 1.06%

from then on. The drop in growth rates is more important than in the previous case.

Figure 9: Productivity-to-consumption ratio, in logs (Japan, 1975–2003)

Figure 10 plots the ratio for the Great Depression. As explained previously, data

limitations prevent us from looking at quarterly data before 1919. However, the

ratio in this case seems to follow a similar “wavy” pattern as in the two previous

figures. It starts at high values, then decreases, reaches a lowest point at the onset

of the Great Depression in 1929, and then reverts back to its level of 14 years before.

Also, average productivity growth rates are declining: 2.82% from the last quarter

of 1919 to the first quarter of 1926, and -.91% later on.

Figure 10: Productivity-to-consumption ratio, in logs (U.S., 1919–1933)

To summarize, this reduced-form analysis points to some similarities between the

three episodes considered, and improves our understanding of the results obtained

through structural estimation. First, in the three cases considered, the productivity-

to-consumption ratio appears to follow a “wavy” shape. Second, average growth

23

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rates of productivity over the periods considered are declining. These two sets of

facts indicate that, in the three cases considered, there was a slow-moving boom and

slowdown of aggregate productivity, together with similar dynamics of consumption,

consumption adjusting with a significant lag with respect to productivity. We would

also like to highlight that this way of looking at the data has the advantage of not

requiring any particular detrending method – a sensitive issue in medium frequency

analysis, and more generally, in macroeconomic time series. In fact, Figures 8, 9 and

10 were constructed with raw (undetrended) data.

3.3 Implications for Debt Dynamics up to 2010, and

Simulation up to 2025

Here we show the historical decomposition of the debt-to-output ratio up to 2010,

and then use our estimated model to simulate the dynamics of this ratio, together

with the evolution of consumption, up to 2025. Our goal is to use our model to get

a sense of the speed of deleveraging and ask: when can one expect consumption to

return to its steady state level after the Great Recession?

To this end, Figure 11 plots a historical decomposition of (detrended) produc-

tivity, net exports and the debt-to-output ratio using only the effect of smoothed

permanent shocks. The level of productivity starts off at a normalized level of 100,

and the other two are normalized at 0. In the case of productivity, the vertical axis

represents log-deviations from the trend. In the case of both net exports-to-output

and debt-to-output ratios, the vertical axis represents absolute percentage devia-

tions from the trend. Productivity first increases due to the permanent positive

shocks shown in Figure 6, peaks around the turn of the century, and starts declining

after that, due to the effects of the negative permanent shocks that, according to

our estimates, start hitting the economy in 1998. The developments of net exports

(and consumption) lag those of productivity, with net exports reaching a minimum

around 2003, and returning to positive values only around 2008. When net exports

are negative the economy accumulates debt, with the debt-to-output ratio reaching

its highest point around 2008.18

The dynamics of debt are determined by three elements. First, they depend on

the persistence of the technology process ρ, because it governs the size of the income

effect and the persistence of beliefs. The higher ρ, the larger the effect of a shock εt18A close inspection of equation (19) reveals that changes of debt away from the steady state are slightly

persistent, which is why the ratio starts declining a bit after net exports turn positive.

24

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Figure 11: Historical decomposition of productivity, net exports, and debt (effect of per-manent shocks only)

of given size in the long run, and the larger the income effect. The larger the income

effect, the larger the accumulation of debt for a shock εt of given size. The higher

ρ, the more persistent the process for ∆xt, and the more persistent agents’ beliefs.

The more persistent agents’ beliefs, the more time they take to realize the end of the

technological revolution. Second, the dynamics of debt depend on the relative size of

the standard deviations σ2v , σ

2z , and σ2

s , because, as usual, these determine signal-to-

noise ratios and thus the speed of learning. The smaller σ2v with respect to the other

two, the slower the learning, and the longer it takes for beliefs and consumption

to adjust. Third, the dynamics are determined by the timing of the positive and

negative shocks. Suppose there is only one positive and only one negative shock, of

same size, and that they hit one after the other in two consecutive quarters. In this

case, the effect of the shocks in the economy would be virtually nil. As shocks spread

out, they can have an effect in the economy, in particular, agents can be optimistic

when the negative shock hits. In the opposite extreme, if the negative shock never

hits, agents are never “surprised”.

Notice that despite the simplicity of the model, and the little amount of data

used for the estimation (only a series of aggregate productivity and consumption),

the dynamics of net exports and debt shown in Figure 11 appear to fit the evidence

on global imbalances, housing markets, and household debt. Indeed, most of the

large deterioration of the U.S. current account deficit took place in the late 1990s

and early-mid 2000s. Also, most of the build-up of household debt started after the

25

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year 2000.

A fun exercise is to use the values of state variables obtained by this historical

decomposition and simulate a forecast of consumption. Figure 12 shows the results.

According to this simulation, consumption would return to its steady state value

only around 2025. Of course, this model is much too simple to take this quantitative

prediction seriously, for instance, the effect of fiscal and monetary policy to fight

against the consumption slump is not taken into account. However, the qualitative

prediction of the model is clear: because the amount of debt in 2010 is large, and

productivity low, the deleveraging process is notoriously slow.

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Figure 12: Simulation of the path of consumption and interest rate up to 2025 (on thevertical axis, zero is the steady state).

27

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4 Preliminary Conclusions

We have explored the possibility that technological revolutions lead to great con-

sumption slumps, using a model with imperfect information and anticipations about

the future. The predictions of the model are intuitive, and provide a simple account

of the Great Depression, the Japanese crisis of the 1990s, and the Great Recession.

In this exercise we have abstracted away from other factors that certainly affected

the most salient of these episodes, i.e. the Great Recession, and also probably the

other two. Among the most important ones, it is relevant to mention the role of

financial deregulation, housing, and financial innovation. However, this abstraction

has allowed us to pinpoint to simple medium-run dynamics common to the three

episodes. These dynamics find a precise meaning in the context of our model.

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ings 89 (2), 116–122.

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29

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A Appendix

A.1 Data Appendix

In the case of the Great Recession, the series for productivity is constructed by

dividing GDP by labor input. GDP is measured by taking the series for Real GDP

from the Bureau of Economic Analysis (available through the Federal Reserve Bank

of Saint Louis online database). The labor input is measured by the employment

series (Bureau of Labor Statistics online database, series IDs LNS12000000Q). The

series for per capita net exports is constructed by dividing Real Net Exports by

Population. The Real Net Exports are measured by the difference between Real

Exports and Real Imports from the St. Louis Fed database (series EXPGSC96 and

EXPGSC96 respectively). Population is from the BLS (series IDs LNS10000000Q).

In the case of Japan, all series come from the OECD website. Real GDP and

Consumption are contained in the measure named VOBARSA. Employment comes

from the OECD website. It is published in monthly frequency, and thus its frequency

was changed to quarterly by computing the quarterly arithmetic average at every

quarter. Population comes from the ALFS Summary tables in annual frequency, and

thus a linear interpolation was performed to obtain quarterly frequency data.

In the case of the Great Depression, all series were obtained from Robert Gordon’s

website.

Our dataset is available upon request.

A.2 Proof of Proposition 1

When C/Y = 1, we can rewrite the equations describing the dynamics of the econ-

omy as

nxt = bt−1 − βbt (20)

ct + nxt = yt (21)

ct = −rt + E[ct+1 + ∆at+1] (22)

ct + φnt = 0

yt = nt (23)

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rt = ψ · bt (24)

Substituting in nxt from (21) yt from (23) into (20), we obtain

bt =1βbt−1 −

1βnxt

=1βbt−1 −

(yt − ct)

=1βbt−1 +

(1φ

+ 1)ct

Similarly, simplifying (22) using (24), we arrive at the two simple equations that

fully characterize the dynamics of debt and consumption

ct = −ψ · bt + E[ct+1 + ∆at+1]

bt =1βbt−1 +

(1φ

+ 1)ct

Let ct = ct + at then

ct = −ψ · bt + E[ct+1]

bt =1βbt−1 +

(1φ

+ 1)ct −

(1φ

+ 1)at .

This system has a solution under the form

ct = Dbbt−1 +Dk

at

xt|t

xt−1|t

zt|t

,

where the coefficients Db and Dk are obtained using the method of undetermined

coefficients. After some lengthy algebra:

Db =−(

1− β − ψ(

1φ + 1

))−√(

1− β − ψ(

1φ + 1

))2+ 4ψ

(1φ + 1

)2(

1φ + 1

)

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and

Dk,1 = − x

1− x

Dk,2 =(1− x) (1 + ρ)− ρ(1− x) (1− ρ− x)

Dk,3 = − ρ

1− ρ− x

Dk,4 =Dk,1ρ

1− ρ− x

where x = (Db − ψ) 1β

(1φ + 1

).

We have limψ−→0Db = −(

1β−1)

(1φ+1) so limψ−→0

β−→1Db = 0. At the same time

limx−→0

(Dk,1

Dk,4

)= 0

and

limx−→0

(Dk,2

Dk,3

)=

11− ρ

(1

−ρ

).

In the end, the limiting dynamics of consumption are

ct =1

1− ρ(xt|t − ρxt−1|t

),

which is the limit of a New Keynesian economy in which the frequency of price

adjustment tends to zero (see BLL for this proof).

A.3 A Two-country Open Economy Model

The model in Section 2 can be extended to two countries. For each variable X of the

home country, denote X∗ the corresponding variable for the foreign country. The

interest rate equation (9) is modified to:

Rt = R∗t + ψ

{eBtYt−b − 1

}(25)

Let m and m∗ denote the population sizes of the home and foreign country respec-

tively.

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An equilibrium is a set of choices {Ct, Nt, Bt, C∗t , N

∗t , B

∗t }∞t=0 and equilibrium

interest rates {Rt, R∗t }∞t=0 such that

mBt +m∗B∗t = 0

and the interest rate spread Rt −R∗t follows (25).

We assume that the two countries have the same steady state growth rate so in

steady state:

R = R∗ =1β

.

In the log-linearized version of this model, we replace the interest rate equations

for the home and the foreign countries, equation (24), by:

rt = r∗t + ψ · bt . (26)

Moreover, we need to add the linearization for the bond market clearing conditions:

mbt +m∗b∗t = 0 . (27)

33